A little bit of knowledge is a dangerous thing

By Scott Sumner

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The following is from a rather disappointing essay in The Economist, which argues that economists have too narrow a perspective:

The measuring rod itself often causes trouble. Not every dollar is of equal value, for instance. You might think that if two economists were forced to bid on an apple, the winner would desire the apple more and the auction would thereby have found the best, welfare-maximising use for the apple. But the evidence suggests that money has diminishing marginal value: the more you have, the less you value an extra dollar. The winner might therefore end up with the apple not because it will bring him more joy, but because his greater wealth means that his bid is less of a sacrifice. Economists are aware of this problem. It features, for example, in debates about the link between income and happiness across countries. But the profession is surprisingly casual about its potential implications: for example, that as inequality rises, the price mechanism may do a worse job of allocating resources.

This is quite misleading, as it implies that the effectiveness of the price system depends on each person placing an equal value on a dollar. This is false. Suppose the apple ends up being purchased by the wealthier bidder, despite the poorer person being able to get more enjoyment out of an apple. Does that mean that resources are not being allocated in a way that maximizes aggregate utility? Not necessarily. For instance, suppose that I was willing to bid $1 for an apple while Bill Gates was willing to bid $2. Also assume that I enjoy apples more than Bill Gates. If a central planner tried to maximize utility by arbitrarily allocating the apple to me, then I’d have an incentive to resell it to Bill Gates for $1.50. This would increase both my utility and Bill Gates’ utility, relative to the allocation of the central planner.

That’s not to say the price system is perfect; there are issues such as externalities and monopoly to consider. But the specific issue of diminishing marginal utility of income is not really a problem of the price system. A better argument would have been that the distribution of income that results from the price system might not be optimal. Then you could have an intelligent discussion of the pros and cons of redistribution of wealth. But that would not have fit the narrative of this article, which focuses on areas that economists need to pay more attention to. No one can claim that economists don’t pay a lot of attention to the issue of equity. (I’d say too much attention–other issues are more important.)

The article then spends a couple of paragraphs complaining that GDP does not perfectly measure economic welfare, a topic discussed in every principles of economics textbook. But the author does not provide a single example of an economic study that is flawed due to this omission. Thus while factors such as crime, pollution and non-market production mean that real GDP is not a perfect measure of welfare, the actual studies that use GDP data often focus on issues such as the business cycle, for which these flaws are of trivial importance.

Similarly, while real GDP per capita is a flawed measure of living standards, it is accurate enough to show the huge gap between poor countries and rich countries. And where RGDP per capita is almost identical, I doubt that you’d find many economists who would argue that the small measured gap (say between the UK and France) is a precise estimate of differences in living standards.

Here is another example:

[E]conomists often work on the basis that tangible costs and benefits outweigh subjective values. Alvin Roth, for example, suggests that moral qualms about “repugnant transactions” (such as trading in human organs) should be swept aside in order to realise the welfare gains that a market in organs would generate. Perhaps so, but to draw that conclusion while dismissing such concerns, rather than treating them as principles which might also contribute to human well-being, is inappropriate. Further, the very act of pulling out the measuring rod alters our sense of value. Though the size of the effect is disputed, psychological research suggests that nudging people to think in terms of money when they make a choice encourages a “businesslike mindset” that is less trusting and generous.

What is “inappropriate” is when a major publication oversimplifies the work of a distinguished economist like Al Roth. In fact, Roth has written extensively about the moral qualms that people have with certain types of transactions. Rather than “dismissing” this issue, Roth has thoughtfully constructed mechanisms for allocating scarce kidneys that do not require monetary compensation. These non-monetary markets have saved many lives. If you are going to argue that economists have a shallow understanding of the importance of non-monetary factors such as “repugnance”, it is be hard to pick a worse example than Roth.

The persistence of repugnance in many markets doesn’t mean that economists should give up on the important educational role of pointing to inefficiencies and tradeoffs, and costs and benefits. But neither should economists expect such arguments to win every debate immediately. Being aware of the sources of repugnance can only help make such discussions more productive, not least because it can help separate the issues that are fundamentally empirical–like the degree of crowding out of altruistic donations that might result from different incentive schemes compared to how much new supply might be produced–from areas of disagreement that are not primarily empirical.

Matthew Moore

May 8 2018 at 9:45am

Ryan Avent

May 8 2018 at 11:57am

Scott, you are assuming that the poorer person values the apple at more than $1 but less than $2, which need not be the case at all. And you are misreading my criticism of Roth, which is not that he ignores ethical concerns, but that he does not consider them to be of value independent of their effect on measurable costs and benefits.

Rojellio

May 8 2018 at 12:49pm

If we are going to consider decreasing value of money as a measuring rod and behavioral economics, then it also implies:

1). Wage and income inequality is vastly overstated as the first dollars are valued substantially higher than later ones.
2). Incentives are greater and more efficient for the lower wage workers, as they are getting more valued dollars.
3). Redistribution is substantially less effective than estimated as behavioral economics shows that gifts are discounted and losses are valued at 2x gains.

Rojellio

May 8 2018 at 3:07pm

If we are going to consider decreasing value of money as a measuring rod and behavioral economics, then it also implies:

1). Wage and income inequality is vastly overstated as the first dollars are valued substantially higher than later ones.
2). Incentives are greater and more efficient for the lower wage workers, as they are getting more valued dollars.
3). Redistribution is substantially less effective than estimated as behavioral economics shows that gifts are discounted and losses are valued at 2x gains.

Mb

May 8 2018 at 8:46pm

I would think the apple example is flawed since you are looking at one side of the transaction. The seller would be much happier with $2 versus $1 and after adding in the buyerâ€™s happiness, I canâ€™t see how a utilitarian could see that as a worse outcome. Then if you add in the multiplier…

Scott Sumner

May 8 2018 at 10:57pm

Ryan, Actually those were simply numbers I used to illustrate the example. Make the values 5 cents and $100 and my point would still hold. The price system is a good way to allocate resources even where people derive a vastly different amount of utility from a dollar’s worth of goods.

And I’m afraid that you have mischaracterized Roth’s views. He may not always agree with the popular view as to what sort of transactions should be viewed as repugnant (and who does?), but he certainly understands the public’s views on this issue, and also understands the distinction between questions of fact and questions of value—as is clear in the final quote I provided. This article gave readers the impression (perhaps unintentionally) that he was blind to this distinction. I encourage people to read his very thoughtful 2007 JEP paper, which discusses many different examples.

(As an analogy, one can be pro-choice without “dismissing” the importance of the unborn fetus.)

Kidney transplants are a very important issue, and Roth’s opponents are responsible for a system which results in many thousands of excess deaths every year. That doesn’t mean they are wrong, but it does show how important it is that we get this right.

Scott Sumner

May 8 2018 at 11:26pm

Mb, No, I am looking at both sides, and both sides benefit if apples are freely exchanged.